Ramblings of a Portfolio Manager

Changing Course

We’ve been criticized for being overly bullish on equities over the last few weeks, paradoxically by institutional brokers who only make money when stocks are going up and investors are willing to buy. But smart brokers use charts, knowing full-well that they can’t count on their own in-house research to even call the direction of the wind during a hurricane, and the charts always tell you to hate stocks when they are going down and to love them when they are going up. Stocks have been going down of late so who are we to fight the tape with such weak arguments as valuation, fundamentals, and economic growth? That being the case, we bow to the chartists, throw in the towel and present here 10 reasons why you should NOT own stocks.

1. Gold. It pays no dividend, costs you a great deal to hold, store and insure the physical asset (assuming you have a safe at home) and carries a 20%+ commission each way on trading it. But it’s going up and the chart guys say that means it’s going up. Sell stocks, buy gold. Someday you will be rich.
   
   
2. Obama. His administration is anti big banks, anti business, fond of high taxes, espouses non-growth producing social programs, and has produced no growth in jobs in his 17 months in office. This, of course, is all information that very few are aware of. All these qualities, naturally, are so popular with the voters that he and the incumbents in Congress are virtually assured of a massive sweep in the mid-term and 2012 presidential elections. We even hear talk of suspending term limits so we may have these excellent statesmen in office forever! Sell stocks.
   
   
3. BP. While the environmental impact is saddening, no one is sure if there will be a measurable economic impact from the spill in the gulf. BP isn’t in any US stock index so it can go to zero without affecting the indices here but we get to see that belching oil on TV every day and that has to be bad. Sell stocks.
   
   
4. Uninspiring retail sales. Yup, 70% of our economy is based on the consumer and the latest round of retail sales reports showed only modest growth. So we shall join in with the bears and proclaim the US consumer dead for the 9,378^th time in the last decade. Sell stocks.
   
   
5. Yields on the 10-Year US Treasuries are now a fat 3.28%. That’s almost a hefty 200 basis points above expected inflation according to the current 10-year TIPS. And, of course, we know that the price of gold isn’t saying ANYTHING about expected inflation (just the super-attractiveness of that asset class). Sell stocks, place a penny into Treasuries (not a bank, the Government tells us they are bad) and sit tight in anticipation of the 2020 Bentley (lighter fuse) you will be able to buy with all those guaranteed accrued interest earnings ten years hence.
   
   
6. Portugal. The rating agencies tell us things are bad there and those agencies employ some of the smartest, most forward thinking experts on Wall Street. And Portugal’s GDP is massive-- almost as big as Arizona’s! This is news. Sell stocks.
   
   
7. Italy. The rating agencies haven’t yet told us things are bad there so things are OK. But if they do downgrade Italy, Sell stocks.
   
   
8. Greece. The ratings agencies tell us things are bad there too. This is also news. Sell stocks.
   
   
9. Spain. Ditto
   
   
10. No-one wants to own stocks now. We all know the herd is always correct. Go with the herd. Sell stocks.

By the way, if you decoded our acronym, give us a call for this week’s picks.

Ramblings of a Portfolio Manager

How to Position Yourself Amid European Turmoil.

According to the databases, the S&P500 just experienced its worst May performance since 1962 while the Dow had its worst May since 1940 and we have Greece, Spain and the rest of the EU to thank for it. Savvy and nimble investors, of course, were able to avoid much of the pain by moving assets to markets less sensitive to the economies of those Sovereign entities, right? Think again. Here’s a little quiz: Now don’t glance at the chart below until you’ve finished reading! In which market would you rather have been invested during the recent ruckus over a potential European debt crisis? 1. The Shanghai Composite—China has the best balance sheet of the developed nations with plenty of reserves and no sovereign debt, however, the EU represents over 20% of Chinese exports. 2. The French CAC-40, which is comprised of companies deriving their earnings principally from the EU, including French banks that would have to write down their book values by over 40% in the event of a Greek and Spanish default. France also admitted at month-end that it would be a challenge to maintain its own AAA debt rating. 3. The S&P500, comprised of multinational corporations receiving only about 10% of their total earnings from the EU. 4. The NASDAQ Composite, made up of high-growth technology and biotech companies earning less than 5% from the EU in total. 5. The US Russell 2000 Index of small cap stocks, which are principally domestic-focused. 6, The German Xetra DAX—Germany is the EU country which will be shouldering most of the burden of pulling its fellow members out of the fire. 7. The Spanish IBEX—need we explain this one? 8. The UK FTSE 100—UK exports to the EU account for about 29% of GDP and the UK Pound has appreciated versus the Euro.

OK, now you can examine the chart below.

The answer, other than the obvious fact that you would have wanted to avoid the Spanish stock market, is that it almost didn’t matter in which developed, Eurozone-affected equity market you invested your money last month—you would have lost a similar amount of money in any of them. The conundrum, however, is that the equity market of one of the most vulnerable countries to a PIGS debacle, France, outperformed almost all of the equity markets in May while stocks in China, with the strongest economy, no debt and the reserves to stimulate, underperformed all but Spain. The FTSE, in a worse position than the US vis-à-vis currency and trade with the EU, outperformed the US. What’s going on? As we see it, there are several countervailing forces at work. First, US hedge fund managers, remembering the debacle of 2008, chose to shoot first and ask questions later—and they tend to be invested more heavily in mid-cap and technology stocks as found in the NASDAQ, the big domestic loser. Secondly, less trigger-happy investors began focusing on the markets where the weaker Euro would be a benefit—the European countries with the largest components of exports in their GDP—and where it would be a detriment—e.g. the US and Chinese multinationals. That’s the reason Germany, with over twice the exports of France, has seen the DAX dramatically outperform the CAC-40 this year and all US and Asian markets last month. Thirdly, the Chinese market is reacting not only to efforts to reign in the property bubble but to the strengthening of its currency versus the Euro, a double-whammy of anxiety. Finally, for the conspiracy-minded, there is the headline timing issue: for the latter part of the month, encouraging comments by politicians tended to come out during the trading day of European bourses (purposefully), allowing them to close higher, while the bad news was saved for “after market hours” (again purposefully) while the US equity markets were still open, sending them lower.. Do that a couple of days in a row (which occurred) and it certainly offers one explanation why the S&P 500 couldn’t put together two back-to-back positive days the entire month while the Euro bourses could. .Fitch’s Friday downgrade of Spanish debt just after the European markets closed but while the US markets were still trading, is a prime example of this.

What to make of this all? Of course this data is all backward-looking but it can give us a clue as to how some markets will perform for the rest of the year. First, we agree with the view that the export-minded EU countries are a buy right now. Several major investment banks have upgraded growth expectations for the stronger, export driven European economies over the past month as did the OECD last week. Secondly, we believe that the sell-off in smaller, US-focused countries is way overdone and that, going forward, they will outperform the large, US multinationals with significant European/currency exposure, especially if the Federal Reserve keeps a rate hike on extended hold, which we think will happen. The stronger dollar will continue to lure overseas investors to our markets and while some of that money will find its way into Treasuries is will also go into perceived “Euro-free” stocks, favoring small caps. Finally, though we have been dead wrong on the Chinese market this year, we have been correct on their economy and we believe that the Central Government will reverse their tightening course as soon as the measures appear to be working (which, as of this morning, they seem to be), especially in light of current world weakness, making Chinese stocks worth a serious look now, after a 20% slide year to date.

Ramblings of a Portfolio Manager

Street Signs

Our apologies to the folks at CNBC for borrowing the name of their daily segment as our tag- line. It just seems to fit so well with the events that transpired last week. We claim no affiliation, imagined or real, with CNBC or its affiliates but if they wish to sue they know how to find us.

We were going to start this piece with “It was a dark and stormy week…” but that seemed a little cliché and a lot Bram Stoker. Instead, we thought we would share some of our observations, which we believe signal that pessimism has reached a fever pitch and, therefore, perhaps a market bottom has been reached. So here, in no particular order but with some subjective commentary, are the top 10 contrary signs we witnessed from Wall Street last week:

1. CNBC ran a weekly segment entitled “anything but stocks.” It covered potential asset classes from Gold, to fine art, to classic cars. The message: stocks are out, collectibles are in. By the way, the illiquidity, the bid/ask spread, and the unregulated fee/commission structure on these “assets” would make a congressman cringe, however, we didn’t hear any indignant Senators grilling Sotheby’s for selling a Picasso with a 20% seller’s discount and a 10% buyer’s premium, plus a listing fee, or for knowingly shorting a ’71 Hemi ‘Cuda Convertible (35% Bondo) for $2mm to a supposedly “sophisticated” buyer bidding from the complimentary bar.

2. More Greek rioting was splashed across the TV (minus the goat, which we are now sure became Gyros for the rioters). The effect on the capital markets was much, much more muted that the first round. Obviously, the Market is becoming desensitized to such media spectacles.

3. Nouriel Roubini was dragged out, after a year of hibernation, to proclaim that stocks could drop another 20%. Why? Because “they’ve gone up so much.” Now there’s some sophisticated analysis for you. The “broken clock” method always seems to work at least once in a lifetime.

4. Meredith Whitney was also put on screen to admonish us “not to touch any financials.” We’re not sure how Multinational Money Center Banks exposed to EU debt share the same risk profiles as regional banks, private mortgage insurers or consumer finance companies. But Meredith had the right call in 2008 and if the broken clock approach worked for Nouriel, why not also for Meredith. Besides, she is a lot prettier.

5. The volatility index, or VIX, spiked upward around to around 45. For the VIX to stay there would mean that the market’s expectation is for very large changes over an extended time frame. In the 15 years leading up to the VIX’s creation in 2003, price changes of 5% or more in either direction occurred only eight times. It is also interesting that the VIX behaved similarly in 1997, hitting a high of 48.64 during the height of the Asian Contagion. Thus far into the European Contagion, the VIX has hit a high of 45.79.

6. Gary Kaminsky, of CNBC’s fast money, officially declared “the death of buy and hold.” He, and many others, said the same back in March, 2009.

7. Jim Cramer is back to his “buy the accidental high yielders” strategy. He pursued this philosophy all the way to the bottom in March and abandoned it only near the top, when the yields were no longer as high. While that might make sense, he never issued a “sell” recommendation so most of his followers probably still hold the stocks he recommended when they were at high yields; while the yields are now lower, investors are still earning the same (if not higher) dividend stream. Unfortunately, they missed the rapid appreciation of some of the lower yield growth stocks on the way up. Chances are they are smart enough not do so again.

8. At least one prominent analyst admonished eschewing stocks while there was “oil in the water and blood on the streets, which is what we have now.” Warren Buffett tells us those are the best times to start buying. We like Warren.

9. The annual SkyBridge Alternatives (SALT) conference of the “smartest guys on Wall Street” took place in Las Vegas amid heavy media coverage. Mass “group think” ensued, as it often does in these conferences (which is why we avoid them), and fed upon itself, with the emergent consensus being that the world was coming to an end and we all must “de-risk.” That is exactly what all the smartest guys did publicly Thursday on CNBC, as they picked up the phones and called in their sell orders. We note that the heaviest selling and biggest drop in the markets came on that day.

10. A public opinion poll showed that Goldman Sachs and Wall Street enjoy a lower approval rating than Congress. Perhaps Bernie Madoff will replace Lloyd Blankfein and Ted Bundy will replace Nancy Pelosi (the latter certainly being a trade up).

11. OK, we said 10 but we couldn’t resist this one. London pawn shops and bullion dealers reported that they are out of gold to sell. ebay is listing gold coins and ingots at 15-20% premiums over spot prices of the metal (by the way, that’s better than the commission those Good Fellas on TV will charge you) and an ingenious entrepreneur just installed several ATM machines to dispense gold ingots instead of currency. We’re not sure how to buy a Big Mac and Fries with an ingot but when we do we’ll be sure to let you know.

We think you get where we are going with all this. Sentiment is very bad, stocks are down and no one is paying attention to fundamentals, which happen to be good. More often than not, this signals a good time to buy stocks and while it is almost impossible to call the bottom, certainly we must be closer to it now than we were three weeks ago.

Frequent bear and always smart guy Doug Kass turned positive on stocks on Friday. Said Mr. Kass,” The market has every reason to lose steam this afternoon, but it's hanging in there. I think that the action today is bullish and we might have seen a bottom for some time to come.” Doug was right in calling the bottom on March 6^th, 2009 but wrong by calling a top at S&P 1020. If his recent track record is only 50%, why do we even bother mentioning him? Well, to start, he correctly called the mortgage crisis of 2008 back in ’07, well before anyone saw it coming, he declared Fannie Mae and Freddie Mac technically insolvent in 2008, enduring derision, and he correctly picked the stock market bottom in March 2009. Secondly, unlike the broken clocks, he is willing to change his opinion as the facts change and he is willing to admit when he was wrong. His picks now: retailers, private mortgage insurers and China. Coincidentally, that happens to be how our portfolio is positioned. Though it isn’t working well at this moment, we expect Kass to be correct and for significant outperformance to lie ahead.

Ramblings of a Portfolio Manager

Ramblings End of Week Update

We’re sure many clients are watching the capital markets with concern. We don’t believe things are anywhere near as bad as they were in September of 2008, however, market sentiment is almost as bad. Because we focus on small caps, our portfolio has been positioned in very US-centric companies, which should not be as directly sensitive to a slowdown in Europe or Asia as would large cap, global companies.

Our philosophy has always been to sell euphoria, buy panic. Right now we have a great confluence of negative events, from the debt crisis in Europe to the Financial Regulation Bill in Congress. The result has been that the fear indicators are reaching levels not seen since 2008. Most of this, we believe, is headline risk only and we are, therefore, taking advantage of the sell-off in select areas with a focus on low P/E, quality companies with strong balance sheets, in line with our long-term investment philosophy. We continue to see improving fundamentals in the US and Asia and look at this as a normal sell-off in a cyclical bull market. We are also putting our money where our mouths are and are investing more in the fund, believing that significant opportunities for appreciation lie ahead.

We encourage any investor with questions or concerns to feel free to call us at any time.

Rick and Chris

Ramblings of a Portfolio Manager

When the Tail Wags the Dog

2% of US GDP. That’s what exports to the entire European Union comprise of our nation’s annual output. Hardly seems worth the volatility that the market put us through last week. Of course, the prevailing fear is the “domino” or “cascade” effect of a weaker EU on the rest of the world and thus, ultimately, the US. We’ve seen this movie several times before. The premier, “Tarp I,” of course, was in September of 2008. The first sequel, “Oh God Obama!,” came in January through February of 2009. The third iteration, entitled “Double Dip,” debuted in July last year. Like all bad movies, the first was better than the sequels—and, as with most movies, it was the “real deal.” The others were just tarted up imposters. Now we have “Contagion IV. The Euro Story.” Is it worth seeing? We think not.

In our little book of investing, E stands for Earnings, not Europe. An excerpt from Ramblings, July 20th 2009:

Anyhow, all we are saying here is that this earnings season should actually turn out to be a good old fashioned one—some beats, some misses, some “in lines.” And that is what makes markets, produces opportunities on both the long and short sides and makes fundamentally-based active money management worth pursuing.

We feel the same way today. Right now the US markets are trading in more or less in direct correlation with the Euro, with exporters getting hit harder than domestically focused companies. We understand the psychology—a strong dollar makes our exporters less competitive vis-à-vis their European competitors and a weak Europe means reduced exports to that trading bloc. But things don’t just work that simply. First of all, as we point out, only 2% of our GDP is based on exports to Europe. Secondly, many of our exporters have no real European competition—think technology and pharmaceuticals. Thirdly, along with a stronger dollar, we have weaker oil (down 20% so far this month), which is like a tax cut for all companies, world wide. Finally, while a weak Euro does mean that European exports to the rest of the world are more competitive, it also means that Europe stands a chance of exporting its way out of an economic slowdown—in fact, UBS upgraded the EU for just that reason today.

We suggest investors turn off the TV and just watch the earnings reports and guidance from the US coming across the tape. It’s a better and more uplifting movie

Ramblings of a Portfolio Manager

Fat Fingers, Thinner Wallets.

It would have been comical had not the financial anguish been so great or the memories it evoked so painful. There, last Thursday, on the right side of the screen were hundreds of government employees expressing their anger and frustration in a childish temper tantrum at the dilemma that they themselves had caused. On the left side was the Dow, tick by tick, dropping with every Molotov, er Metaxa cocktail let fly. We’re talking, of course, about the Greek Government Union employees rioting at the austerity cuts mandated by the EU bailout package. The would-be comical part was the goat, seen in all the videos, running helter skelter amid the chaos. The not-so-comical part was the close analogy it drew to another scary media spectacle just 19 months earlier. There too, hundreds of childish government employees vented their feigned and hypocritical wrath at a situation that they also caused while the world watched the capital markets fall, tick by tick. That, of course, was the vote on the TARP bailout bill in Congress. Unfortunately, in that scenario the only goat (the “scape” kind) was Hank Paulson, who had to take the blame from grandstanding hypocritical Senators (e.g. Barney Frank) for a situation he certainly didn’t cause but was clearly using all his powers to avert. The Greek goat probably ended up as Souvlaki, roasted over the trash fires by hungry cops (we noted that all the donut shops had already been looted by the other Unions). The American goat, thanks to our more “mature” society, was labeled “damaged goods” and got to write a book that helped augment his stack of T-Bills. It’s a great country.

Amid the televised media spectacle investor panic sent the Dow down almost 1000 points intraday before recovering almost 700 of those points. We’re not qualified to even speculate upon the reasons for the resultant gut-wrenching move, which occurred in just 15 minutes, so we’re not going there…although there is a “grassy knoll” theorist around here who is convinced it was all the work of cyber-terrorists. We’re going to give him some time off to spend with a certain Police Chief we recently had to let go in part due to his conviction that the local nut case who was blowing up porta-potties was in truth an Al Quaeda cell practicing for an attack on the Empire State Building. On second thought, that nut case was released just last week from the hoosegow…hmmmm.

Instead of opining on last week events, we thought we’d give a little test to see who was paying attention. Ready? Here are some headlines from last week. Music please! One of these things is not like the other. One of these things just doesn’t belong. Can you tell which thing is not like the others by the time I sell all my longs?

a. EU Raises 2010 GDP Forecast
b. China’s October Manufacturing Grows at Faster Pace
c. Oct. ISM Factory Index Surges to 55.7%
d. World Equity Markets Lose More Value Than the Combined GDP of the PIGS
e. U.K. October House Prices Gain for Third Month
f. UK Manufacturing PMI at Two-Year High
g. US Employers add 290,000 jobs, Twice the Consensus
h. Australia Increases Benchmark Interest Rate to 3.5%
i. Barrons says “here's a chance to shop for stocks.”

Time’s up! The astute among you noticed immediately that this was a trick question as we all know that Barron’s wound NEVER publish a bullish article on stocks. Right? Wong! Actually, they did. May 8th: “Try not to get rattled by the market rout. Instead, here's a chance to shop for stocks.” Go figure. So the correct answer is “d.” Yes, world equity markets did indeed erase more in value than the entire combined GDP of the PIGS (approximately $4Trillion) in just 4 days last week, which flies in the face of all the positive (in some cases too strong) economic data from around the world. Keeping it all in a Fred Rogers framework: “Over reaction. Can you say that?”

OK, for those of you who missed it, here’s another, easier little test:

Question: Which country is the largest exporter to the EU?

a. United States
b. China
c. Japan
d. Australia
e. Germany
f. The EU

Also a trick question. Yes, the EU is the largest exporter of goods to itself. However, within the EU, Germany is the largest sovereign country to export to the EU and the second largest exporter in the world, after China. The US comes in third in world rankings. Why does this matter? Well, with all the handwringing over the world impact of a European slowdown, one should consider who will be affected first. China, as we all know, is in the midst of a tightening phase due to excessive economic strength. Germany was about to go there before the Greek mess hit and the US is still contemplating tightening after already beginning the liquidity withdrawal. These countries, if beset by export declines due to EU weakness can turn their monetary policies on a dime, as they did in 2008. That, in our opinion, would start the liquidity cycle all over again, driving up stock prices, among other effects. So, while we realize that the story isn’t just Greece but the so-called domino effect across Europe and that all the positive data coming out of countries right now is “rear view mirror” information, we also understand that there is a fair amount of firepower left in the largest economic powers to prevent another financial crisis, which is what the markets fear is happening now.

Oh Oh! As Rosanne Rosanadanna would say, “never mind!”

Timing is everything and as we write this we see that the EU Ministers have approved a $962 billion fund to bolster the Euro and to stave off further debt-crises in member countries. In one fell swoop, this move takes the PIGS off the table. Along with the loan package the European Central Bank will initiate their version of “quantitative easing,” something that last week its president, Jean-Claude Trichet, said the central bank didn't even contemplate. The ECB will go into the secondary market to buy euro-zone national bonds and the Federal Reserve has re-activated swap lines so foreign institutions can get access to loans. It’s an unprecedented move from what here-to-now has been an agonizingly slow, almost constipated, European bureaucratic system. It’s also surprising show of cooperation among central banks. The markets seem to like it and as of this writing Dow futures are up over 400 points.

So as the CNBC junkies cover their shorts in the Euro, let us praise the EU Ministers, mourn the goat and remember that you heard of this first on Ramblings: Special Edition, last Thursday.

Ramblings of a Portfolio Manager

Greek for Dummies… and PIGS

With all the news surrounding the PIGS last week, particularly Greece, we thought it would be helpful if we provided a little primer to help investors understand some of the more complex Hellenic financial terms flying around the airwaves. So here, in the language of Aeschylus, is the week in review:

hypokrites. n. Gk a stage actor, hence one who pretends to be what he is not. See also oraculum. v. L to plead. ME hypocrite: one who denounces derivatives as “financial weapons of mass destruction” prior to emerging as one of the largest investors in said weapons and criticizing the Government’s plan to regulate such.

amnestía. n. Gk oblivion. See also ME hypocrite. ME amnesia: a group that protests the “cost to taxpayers” of bailing out Wall Street, which paid the Government back in full plus interest, “forgetting” that its own constituency placed taxpayers in the same situation with GM, receiving ownership in the Company in return while being allowed to pay back those taxpayers with their own money ( i.e. TARP funds).

phone. n. Gk sound, voice. See also L senatus, council of elders. See also ME hypocrite. ME phoney: 1: someone who takes money from another and in return puts the donor through a public show trial to enhance the probability of re-election. 2: public criticism of an institution for “adding no value” by an individual who destroys value. See also slang doddism n. cognitive deterioration.

moros. n. Gk foolish, stupid. See also ME worthless. ME moron: 1: one who helps create a global Standard of being Poor. 2: a group or entity paid to opine on the financial health of another and who, having failed spectacularly, downgrades the debt rating of a sovereign entity in obvious financial distress, after the value of that entity’s bonds has already declined 38%, hoping no-one notices.

eirene. n. Gk oil. See also ME double standard, fr. Gk diploos + histanai, to cause to stand twice. ME oil: A value system under which an environmental disaster is never the fault of philosophically liberal politicians or government entities, even when they publicly support the conditions that created the disaster in the first place.

Next week, depending upon which of the PIGS makes the headlines, we will explore the romance languages.

Please call for this weeks highlighted stocks.